HOW THE PRUDENT ANGEL INVESTOR CAN SURVIVE THE DOWN-ROUNDS

INTRODUCTION

“Down-rounds” have become a critical challenge for angel investors. These are the declining valuations that often accompany the entry of new investors into subsequent financing rounds. In some cases, down-rounds are substantial enough to severely diminish or eliminate entirely the equity stake held by angels and other early investors.

Angel investors are often quick to criticize venture capital investors (VCs) for down-rounds. However, angels who are careful about keeping their eye on the ball are much less likely to suffer heavily in down-rounds. VCs and angels may exhibit differences in approach and may be driven by different prerequisites. Nonetheless, the two have much in common. With better attention to detail and a better understanding of the VC process, angels can make early-stage investing a more congenial and rewarding experience.

How does the prudent angel avoid getting burned in down-rounds? The primary rule of an angel investment – as with any investment — is to plan for one’s eventual exit. Angel investors need to consider their exit strategy from the outset, and continue to do so through the entire investment process to payout. Only the naïve will expect later-stage investors to look after their interests

THE INVESTMENT CLIMATE

By the end of 2002 and into 2003, the environment for early-stage financing had become as discouraging as it has been for the past 25 years. Little money was being invested and fear tended to dominate investment decisions, making negotiations difficult and seriously reducing risktolerance.

This tough environment intensified the inherent conflicts between angels and VCs. While many angels pointed to VCs as the source of their problems, the truth is that both angels and VCs found the investment climate trying, albeit for somewhat different reasons. However, with a little perspective, angels can understand the venture capital process better and thereby improve their own positions.

The prudent angel investor knows and understands his competitors and his allies.

VCs AND ANGELS ARE BOTH EARLY-STAGE INVESTORS

The earliest investors frequently include the company’s founders, the management team, friends and family, and angel investors. Some venture capitalists may enter at this early stage, though this is unusual. It is often a mixed crowd that supports an early-stage venture, but what these investors share is a powerful interest in growing the company. These people are investing in the future, based on what they know about the talents of the management team and its ideas and products.

In contrast, later investors generally have a better sense of the business’ prospects, and are investing on the basis of visible results rather than personal knowledge, instinct or experience. These later investors, who are almost exclusively venture capitalists, are interested in making deals that will bring a good return within a specific time frame. While some VCs look at the bigger picture and are comfortable with long-term investments, many prefer to earn a healthy return with a quick turnaround. Liquidity is a key consideration, as venture capital funds must generate a steady return for their investors.

This need for relatively quick returns on investment often push VCs to sell an equity position sooner rather than later. In so doing, they may leave early investors and managers with nothing but bitter experience. Naturally, this is a key source of tension between angels and VCs. However, since this is a well-known element of

Prudent Angel Investor

early-stage investing, it is sensible to plan for the eventual entry of secondary investors. The prudent angel will learn as much as possible about the role and motivations of VCs, and will also attend closely to the start-up’s stage of growth and need for new capital injections.

BEGIN WITH A REALISTIC APPRAISAL OF THE INVESTMENT

Entrepreneurs are enthusiasts by nature and will occasionally woo investors with grandiose predictions of how much revenue they can generate over a short period of time. It has not been unheard of for start-ups to boast expected revenues of $5 million or $10 million or more. And yet, a simple review of available statistics quickly reveals how inflated such projections can be. A recent survey ranking the top 100 independent software companies in Canada in 2001 (Branham 100, www.branham.com) noted the following:

Only 63 of the 100 had revenues of over $10 million a year.

The companies had, on average, been in business for 15 years.

The 100th ranked company on the list had revenues of only $2.8 million.

These figures illustrate how risky it is to place one’s trust in an entrepreneur’s earliest projections. As early-stage investors, angels often get swept up in management’s enthusiasm. Instead, they need to put their financing on a more cautious footing and ask themselves: “If these sunny projections don’t materialize, how am I going to protect myself when the company goes back to the market for more money?”

MONITOR THE INVESTMENT FROM THE OUTSET

The prudent angel investor will ask for best and worst-case projections at the outset and assiduously track results against them. Angels need to know when the company’s course deviates from expectations, and when it does, be prepared to take the necessary steps. These may include a further personal investment, joining the Board, helping with marketing, finding a purchaser for the investment, writing-off the investment, finding additional angel investors or providing stronger incentives for management to deliver.

THE ENTRY OF THE VENTURE CAPITAL INVESTOR

Let’s assume the angel investor has retained his investment. A few years have passed and the early, enthusiastic, hockeystick revenue projections are a distant memory. The company has built a solid foundation and is now attracting interest from venture capitalists. This is great for the company and may help it to realize its goals. However, angel investors must be aware that their situation changes with the entry of the VCs.

Once in, the VCs need to make a quick exit in order to provide a constant flow of income to their investors. They also need to leave some value in the company for managers to ensure the necessary incentives are in place to continue growing the business. However, as noted above, early-stage investors can easily get squeezed out.

Having provided the initial capital for growth, the prudent angel is alert to the ongoing need to protect and build his investment. Fortunately, there are several mechanisms available to help him. These include averaging down, the use of formal debt instruments of various sorts, guaranteed pay-outs, management fees, finders’ fees, shotgun clauses triggered by share dilution and representation in the form of directorships, among others.

THE GAP

In truth, new businesses rarely begin generating revenue momentum — or VC interest — until the third or fourth year of operation. This may be too long for many angel investors to wait, as the risk is simply too high. Consequently, there is often a gap between the time when angel investors should or must get out and venture capitalists are ready to come in. The result can be a stalemate in which all parties withdraw from the game — VCs because they can’t get the requisite returns within the requisite time frame, companies because they don’t like the terms of investment and angels because they don’t want to risk more money.

Ideally, the prudent angel identifies the need for more money early on, and works with the investee to pinpoint and attract a venture player whose terms are mutually agreeable. Unfortunately, the reality in today’s environment is often rather different and angel investors must be prepared for it.

THE RETURN OF REASONABLE VALUATION

Returns in almost every market, from equities to venture capital, have fallen during the past two years. In hindsight, the real question is not why the fall occurred, but why it did not happen sooner. Valuations between 1998 and 2000 were outrageously high and added to investors’ uncertainty about how to assess risk. Amid all the energy and excitement that surrounded the late 1990s, people began using bizarrely high multiples, overly optimistic forecasts, market share projections and other novel methods to estimate potential success. None of these novel methods lasted beyond the bubble.

Thankfully, the past two years have seen a return to the fundamentals. Investors of all kinds are looking at conventional valuations (based on actual earnings, revenue, cash flow, and other tangible indicators) and conservative valuation strategies using lower multiples and more realistic forecasts. Indeed, the pendulum has swung back with a vengeance.

Everybody has been affected. Early-stage companies, financed by angels at the height of the madness, are now being funded at reduced valuations. Of course, this puts a further financial squeeze on angel investors. The prudent angel is just as likely to have been swept up in the madness as everyone else – and just as likely to be looking at lower portfolio valuations.

The solution lies in formulating strong funding and defensive strategies. Angels must ensure that an investee company has a solid business plan outlining how and when it will deliver promised results. They should also be prepared to supplement this by providing hands-on management and marketing assistance, as required. In portfolio terms, the prudent angel will focus careful attention on the fundamentals, including value propositions, sales channels, competitive advantage, market size and product and service differentiation.

Moreover, angel investors must remain keenly aware of developments affecting their investments. If restructuring is required, then the investor should try and lead it – by contacting management and other stakeholders to arrange for financing. By being the initiator, the angel investor will retain a measure of control and reduce the risk of being squeezed.

PARTICIPATING IN LATER ROUNDS

At some point, there will be a later round of financing. For angels, this can be an opportunity – after all, a down-round is a good time to invest as businesses have reduced their valuations, the inflated sales figures are flapping like torn flags, and management is increasingly eager to negotiate. However, the decisive factor for further investment must be sustainable profitability. Clearly, bubble-type valuations have had a lasting negative impact and investors and managers have become more concerned with building profitability. The prudent angel will have also adopted profitability as the fundamental element in investment valuation.

PREPARE FOR THE FUTURE AND BE READY TO STAY IN THE GAME

Angels who have prepared for the next round of financing will have already determined their course of action. If not, they still have a choice. They can enter the next round, where a better deal is being offered (in essence, averaging down, but retaining some control over the dilution); they can hold tight and watch their investment be diluted (the classic squeeze); they can scramble for leverage and payback (management fees, fees for services, directorships, shot-guns); or they can pull out.

Clearly, early preparation works better than last-minute scrambling, and enables the angel to plan how best to participate in later rounds. For example, if an angel reduces his initial payout, this can leave funds in reserve to enable reinvestment at the next stage. This allows the investor to get in on the ground floor and help build the company, while participating in the terms and benefits that go along with later-round financing. It also gives the angel leverage in new rounds and keeps the door open between the angel and the VCs, which is key to cooperative investing and, in effect, bridges the gap between the first and later rounds.

To reiterate, the prudent angel must be prepared for the next round of financing and has already planned the route that is most workable.

CO-OPERATION CAN PROVIDE MUTUAL BENEFITS

There is great value to be had in today’s market. After a couple of years of blight, even big brokerages are beginning to take an interest in small, well-run companies. In one recent deal, management, a national brokerage, VCs and angel investors were all involved at the same time. The company had positive cash flow and money in the bank. The arrangement seems to be working even though the compound annual growth rate isn’t quite at 30 per cent, which is something of a concern for the VCs. But the pricing was simply too good for the players to resist.

In this case, all management needed for continued growth was funding. The investors are working together to make sure management has what it needs. None of the participants wanted this company to fall into the angel / VC gap, and took steps to ensure this didn’t happen.

The lesson from this example is that the prudent angel welcomes partners who can help the investee.

KEEP YOUR EYE ON TOMORROW

There are two key questions for every early-stage company: “How do we attract money today to build the business now?” and “How do we make this business grow into the future?” Angels need to focus on the same questions on behalf of their investees and keep in mind that the past is history. The world has changed, valuations have changed and priorities have changed. An angel cannot change what has already happened. If VCs have already bitten into the investment, the challenge is to find a way to make the most of the flesh that remains.

Angel investors are better off than they were two years ago, though they may not realize it. The reason is that investees are generally better managed today and more focused on revenues and profitability than ever before. Many of them are showing they can survive with a delayed or even evaporated second round. Also, as noted above, there is a small resurgence of investor interest in early-stage companies. While not definitive enough to constitute a trend, dollars are slightly more accessible, which will help to close the angel / VC gap, at least for some lucky companies.

The involvement of venture capitalists could hurt if there is a big down-round. However, valuations today are such that many angels will want to stay involved with their companies and participate with later-round investors. They can, in fact, help to reduce VCs’ anxiety about valuation by maintaining or building both their presence and their investment in the target company.

The prudent angel investor talks with VCs about valuations and how to realize intrinsic worth in their investees.

BUILD RELATIONSHIPS BASED ON TRUST

VCs are looking for quality deal flows. For this they need good relationships with those in the business community – including angel investors. Angels can provide access to a world of deals that VCs wouldn’t otherwise know about. This change in philosophy has been noticeable in the term sheets turning up recently.

There is no question that some VCs – driven by fear and the need for quick returns – squeezed some early investors unconscionably. There were more than a few very ugly deals. But the good faith required for successful business dealings cannot grow when one side is taking untoward advantage of the other. The ridiculously lopsided terms that were common in the recent past have begun to give way.

The prudent angel investor will look for mutually rewarding relationships and will not judge all VCs by the actions of a few.

BE PREPARED TO COMPROMISE

The key to a new relationship between angels and VCs is compromise. Relationships take time and both sides have to learn to trust one another and to support one another’s objectives. Even when the goals of the parties no longer align, if the relationship is strong, it is possible to get through with grace and dignity.

The benefits of compromise also apply to investment targets. Given the current environment, investors should aim for smaller profits on more deals and greater diversity in their portfolio to spread risk and enhance income. This goes for angels and VCs both.

BUT ARE VCs WILLING TO TAKE LESS INTERNAL RATE OF RETURN?

VCs are beginning to look at things in the longer term. The late 1990s saw an unbalanced market and a very demanding and somewhat unrealistic set of investors. Today, many VCs have learned that, as an early-stage investor, a short-term approach to making money just doesn’t work. Many are beginning to realize that the tough provisions inserted in term sheets when valuations were unrealistically high need to be altered now that valuations are more reasonable.

Slowly, the market is changing. At a recent venture fair, several major VCs made it clear that they were not interested in seeing companies project revenues of $100 million within five or seven years of start-up. They even suggested that their earlier demands had resulted in a whole generation of managers making unrealistic projections just to get on the radar screen. Another venture fair conversation featured a VC who had left the industry because he felt that the VC model resulted in too much money coming out of early-stage companies too soon.

There are good and bad VCs, and most angels would rather deal with VCs who never participated in the scurrilous squeezes. However, in this changing market, angels must be willing to look past VCs’ recent behaviour, because, realistically, there isn’t much choice. In tough times, any VC who is willing to get involved in a project and who has money is a good candidate for later round financing.

That being said, however, angels need to look to themselves. Based on their years of experience, relative freedom, and closeness to the investees, it is their responsibility to behave like the professional investors they are. That means building on their knowledge and experience to establish workable term sheets that provide reasonable protection. It means structuring various types of investment arrangements, creating measurable and monitored goals for investments and holding themselves accountable for the performance of their money.

Prudent angel investors cannot sit back and blame management, the VCs, the investment climate, commodity pricing or the telecom upheaval. Instead, they must realize that they have at their fingertips the resources to make good and profitable investments.

What resources? At the very least, they have each other in Canada’s increasingly active and organized angel network. And they have the experience of working with their fellow investors – the VCs and the brokerages. They need term sheets. They need regular meetings with management. They need to be kept in the loop and to keep themselves informed. They need metrics. They need to track investments against stated and communicated goals. They need to know how to say “no”. They need an understanding of business models, business management techniques and valuation criteria. Because, let’s face it — if they had invested as professionals in the first place, it would have been much harder to squeeze them.

The prudent angel investor treats his or her investments as a business.

As they develop national expertise, angels need to focus on ensuring a better and more business-like working relationship with both investees and other investors. This will go a long way to helping bridge the gap between angel investors and venture capitalists.